• HDFC securities
• 27 Mar 2023
• Knowledge Centre

8. What is margin of safety?

 

Jason Zweig, a US-based financial columnist, in A Note About Benjamin Graham in the book The Intelligent Investor writes: No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety” — never overpaying, no matter how exciting an investment seems to be — can you minimize your odds of error.

Benjamin Graham is considered as the father of value investing. He was the first person to have solidified the concept of ‘margin of safety’ and presented it in his seminal book ‘The Intelligent Investor’. The concept has since been used and further developed by generations of value investors including Warren Buffett and Charlie Munger.

Margin of safety

Margin of safety is not a novel concept. You come across it in everyday life. For instance, the actual expiry date of most medicines is not what is written on the bottle. Pharma companies keep a margin of safety and print expiry dates much before the actual expiration dates.

Using another analogy from everyday life, Buffett famously explains the concept: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.” That 20,000-pound difference is the margin of safety.

Let’s understand this with an example from the stock market. You are an engineer working in the coal mining industry for many years. Naturally, you understand the nitty gritty of the coal mining business. You have spotted a coal mining company – Indian Coal Mining Limited (ICML) -- that has a very good business model and growth trajectory. Thus you want to invest in that company by buying its shares.

The problem now is at what price you should buy those shares? For that you need to calculate what is the actual value of its shares – also called intrinsic value. This is a complex calculation based on certain assumptions and a deep understanding of business. However, given your understanding of the industry, you have a fairly good idea of the intrinsic value of ICML shares. After the calculation, you found it to be Rs 100. Incidentally, the stock also trades at Rs 100 today.

So, should you buy the stock for around Rs 100? The answer is no, at least according to Graham. However good you and your assumptions are, there is a risk that they can be wrong. So, you need to factor in the cost of going wrong. Let’s just say if some of your assumptions go wrong, the intrinsic value of ICML shares will slide down to Rs 70. Now, this difference (Rs 100 minus Rs 70 = Rs 30) is your margin of safety. Ideally, you should try to buy the stock for around Rs 70.

Intrinsic value formula

There is no formula to calculate the margin of safety as that is subjective. Though Graham does provide a simplified formula to calculate intrinsic value. You can apply your preferred margin of safety (for example Buffett usually prefers margin of safety at 25 per cent) to the intrinsic value.

The Graham formula proposes to calculate a company’s intrinsic value (V) as:

V = [EPS x (BPE + Cg x g) x 4.4]/Y

EPS = the company’s last 12-month earnings per share

BPE = P/E base for a no-growth company (Graham use d 8.5)

Cg = Multiplier to the growth value (Graham used a value of 2)

g = reasonably expected 7 to 10 Year Growth Rate of EPS

4.4 = the average yield of AAA corporate bonds in 1962 (Graham used the prevailing rates)

Y = the current yield on AAA corporate bonds

 

The formula was revised and published in 1974 by Graham. However, since then it has lost some of its relevance and may need adjustment to cater to modern standards of growth and PE valuations.

For instance, Cg needs to be lower as companies now typically grow in double digits compared to single digits when Graham devised this formula. We will be using Cg as 1. Similarly, BPE also needs to be reduced as even those companies with no growth are able to generate cash and distribute dividends. For our purpose any value between 7 to 8.5 is fine – we will be conservative and take BPE as 7. The average yield of AAA bonds (4.4 in the formula) also needs to be revised. We are going to replace it with an interest rate on 5-year fixed deposits. 

After certain tweaks we come to this formula:

V = [EPS x (7 + g) x 5.65]/Y

After putting in values in the formula you will get the intrinsic value. Though be aware that this formula is not a replacement for valuation models used by analysts. It just provides a rough estimate of intrinsic value. Now, keep this in mind,

-              If V > current market price, the stock is undervalued

-              If V < current market price, the stock is overvalued

Applying the principles of margin of safety, you need to find the undervalued stock. That is, intrinsic value needs to be higher than the market price. You can decide how much margin of safety you want. Anything between 10 percent to 30 percent is used by value investors.

Margin of safety in accounting

The margin of safety has another definition that is used in accounting. It is the difference between the amount of expected profitability and the break-even point. It is derived as current sales minus the breakeven point, divided by current sales. Though, it is a similar concept but not the same thing. As an investor, you should not confuse it with the one that Graham came up with.